Goldman strategists weren't the only ones surprised by the swift
move. Citi
strategist Matt King expressed a similar sentiment in a note to
clients on January 4, writing, "While CDS has already shot through our 2013
year-end targets (!), cash still has another 20 basis points to
go."

Société Générale credit
strategists Juan Estaban Valencia and Suki Mann reflected on the
strong demand for credit that has underpinned the January rally
in a recent note as well, writing, "We’ve had one of the
best starts to a year in the primary markets for investment
grade, the best ever for high yield, and the
best month for senior financials since January 2010, which
underscores just how strong appetite for credit remains, even at
the current pricing levels."

The chart below, via BofA
Merrill
Lynch, shows the size of the rally in credit – and how it has
mostly tracked that in other risky assets like the S&P 500
that began in November.

The big spread tightening in
the credit space that occurred when a deal was reached on the
"fiscal cliff" is what caused so many Wall Street strategists to
blow through their year-end targets only a few days into
January.

BofA Merrill
Lynch

However, that uptick circled in the chart above – a significant
sell-off in corporate debt at the end of the month – has people
talking.

(A quick primer on credit investing: the "spread" refers to
the difference between the yield on a corporate bond and that on
a government bond. Yields on all bonds are inversely related to
bond prices. So, when the spread "tightens," it either means
investors are buying up more corporate bonds, sending yields on
those bonds lower, or they're selling government bonds, sending
yields on those bonds higher.)

The "Great
Rotation" Versus The Real Threat

At the end of January, there was a sizeable correction in credit
that was not reflected in equity markets.

The correction was to be expected after such an astonishing run.
Now, Valencia and Mann at
Société Générale write, "the bigger question is whether we are
witnessing a healthy correction or a more sustainable shift out
of credit and into other asset classes."

Other banks are getting the question a lot, too. Citi
strategist Stephen Antczak writes in a
note, "Many
corporate investors are increasingly worried about a rotation
from credit into equities, particularly one that is prompted by
higher Treasury rates."

While a rotation may or may not
be happening – at least, not yet – it's undeniable that Treasury
yields are rising. Last week, the yield on the 10-year Treasury
climbed past 2 percent for the first time since April.

Antczak says regardless of the
flows, rising Treasury yields in and of themselves are a big deal
for investors in corporate credit. His latest note to clients
sports a rather ominous title: "How Afraid of Rising Rates Should
We Be? More than usual."

In the note, Antczak stresses
how exposed investors in corporate debt are to rising Treasury
yields and points to a few major causes for concern.

The Rise Of Mutual
Funds

The first thing to remember,
writes Antczak, is that mutual funds and ETFs together are
responsible for a big portion of the marginal flows into
corporate credit markets in recent years. Mutual funds now
account for $1.7 trillion of the market, up 69 percent from the
first quarter of 2009, and ETFs are responsible for $200 billion
– up 328 percent in the same time period.

The chart below should offer a
sense for the importance of mutual funds and ETFs (along with
life insurers, which have also piled into corporate debt in
recent years).

Citi
Research

Antczak explains why the rise
of mutual funds and ETFs in the corporate debt market –
reflecting increased access for retail investors – is so
important (emphasis added):

The problem is that these
investors tend to be backward-looking and sensitive to total
returns, particularly negative total
returns. And if
10-year Treasury rates were to riseanywhere
near what our economists expect(again, 2.5% by year end) total returns in
the corporate market may very well be negative. And if returns do
in fact turn negative, we would expect investors toscale back mutual fund investments,
creating forced sellers.

Forced selling is a problem
when there is no one else to take the other side of the trade.
Making the situation worse is the amount of risk investors in
corporate credit have taken on as of late.

Record Levels Of Duration Risk In Corporate
Debt Markets

Mark-to-market
risk in corporate debt – as measured by DV01 – is at an all-time
high.

Note: The term "DV01"
– short for "dollar value of an 01" – refers to a bond's
dollar duration, which simply measures the amount
of money a bond investor will lose on a $1 million bond
investment for every 1-basis point rise in the yield on the
bond.

Zero interest rate monetary policy in developed economies
has pushed investors to take on more and more duration risk in
their portfolios. With lower interest rates across the spectrum
of maturities, investors move to longer-term debt to collect
yields previously available from shorter-term debt. The problem
is that the value of longer-term debt is more susceptible to
changes in interest rates – hence the duration risk.

In other words, corporate bond prices
are extremely sensitive right now to a rise in
interest rates. The amount of money an investor stands to lose on
his or her corporate debt investment for every uptick in yields
(remember, yields and bond prices are inversely related) is at
historic levels.

The chart below shows DV01, which Antczak characterizes in his
note as "WAYabove its long-term average."

Citi Research

Antczak writes, "Extreme mark-to-market sensitivity and
extreme mark-to-market risk in a rising rate environment can’t
be a good combination."

The
Endgame

Credit markets have undergone a substantial metamorphosis in
recent years as a world of ultra-low interest rates has forced
more and more investors – searching for yield opportunities –
into investment grade and high yield corporate debt.

Now, everyone is on the same side of the trade. The changes in
corporate bond holdings among various types of investors
charted above lead Antczak to conclude that "essentially everyone that has been adding
risk is real money, long-only investors."

This leads to an important
question, says Antczak:

"If mutual funds and ETFs are forced to
sell, particularly given that the Street is still not willing
to boost risk positioning, who will take the other
side?"

The answer: "Perhaps no one,
at least not until valuations cheapen meaningfully."

For their part, Valencia and Mann at Société Générale
don't see the recent pull-back in corporate debt as
"anything more
sinister than some heightened nerves following a tightening
that was overly aggressive as we kicked off the year."

However, according to the two
strategists, the sell-off does highlight a major concern – the
same one hinted at in the question posed by Antczak
above.

Valencia and Mann write,
"the difficulties the
Street faced to absorb one way flows recently highlights how
vicious a more structural unwind could become (when we get
sustained growth) given the lack of accommodation of emerging
bonds from the Street when we get a sell-off."

As mutual funds have bought up debt in recent years, dealers
have seriously pared back inventories.

King put it this way: "Second, market
liquidity. Since 2007, credit mutual fund assets have doubled,
while dealers' corporate bond inventories have halved.
So while in 2007, it
would have taken a 50% outflow from mutual funds to double the
size of the street's inventory, now if there were to be a 5%
outflow it would double the size of the
inventory."

Valencia and Mann point to
this as a sign that "the dynamics of the market have changed in
that sense," and conclude with a warning for clients:

...for now, while the going remains good for
continued tightening in credit spreads, the exit will be
messy. Hopefully, that's not something we need
to be concerned about for some time yet. So, for the moment, we
have a correction, the entry points look/are better although
few will be tempted to add - until, of course, someone else
goes first.

All of this assumes that
interest rates continue to rise in 2013 – but that's exactly
what many are forecasting right now.

In the "forced selling"
scenario described above, Citi's Antzcak thinks corporate
credit spreads would eventually tighten "once the dust
settles," but cautions that the path to that end state could be
a rocky one.